The "Real Pain" Is About To Begin As Chinese Currency Slumps To 19-Month Lows

The PBOC's willingness to a) enter the global currency war (beggar thy neighbor), and b) 'allow' the Yuan to weaken and thus crush carry traders and leveraged 'hedgers' is about to get serious. The total size of the carry trades and hedges is hard to estimate but Deutsche believes it is around $500bn and as Morgan Stanley notes the ongoing weakness means things can get ugly fast as USDCNY crosses the crucial 6.25 level where losses from hedge products begin to surge. This is a critical level as it pre-dates Fed QE3 and BoJ QQE levels and these are pure levered derivative MtM losses - not a "well they will just rotate to US equities" loss - which means major tightening on credit conditions...

CNY hits a critical level at 6.25...

This is a major problem because...

The seemingly incessant strengthening trend of the Chinese Yuan (much as with the seemingly inexorable rise of US equities or home prices) has encouraged huge amounts of structured products to be created over the past few years enabling traders to position for more of the same in increasingly levered ways. That was all going great until the last few weeks which has seen China enter the currency wars (as we explained here). The problem, among many facing China, is that these structured products will face major losses and as Morgan Stanley warns "real pain will come if CNY stays above these levels," leading to further capital withdrawal, illiquidity, and a potential vicious circle as it appears the PBOC is trying to break the virtuous carry trade that has fueled so much of its bubble economy.

As we noted previously... The total size of the carry trade is hard to estimate although even just looking at some of the onshore CNY positions accumulated, DB Asia FX strategist Perry Kojodjojo estimates that corporate USD/CNY short positions are around $500bn. The size of the carry trade and the fact that China saw significant capital outflows during the last period of substantial Renminbi depreciation in the summer of 2012 has led to concerns over what this might mean for both the Chinese economy and financial markets as well as broader global financial implications.

Morgan Stanley believes that one such carry-trade structured product that will be the "pressure point" for this - should the Yuan continue to depreciate - is the Target Redemption Forward (TRF) which has a payoff that looks as follows...

While this is just an example of a product payoff matrix to the holder, the broader point is that the USD/CNH market has a particular level (or range of potential levels) at which three factors can create non-linear price action. These are:

1. Losses on TRF products will (on average) crystallize if USD/CNH goes above a certain level. This has implications for holders of TRF products, who are mostly corporates;

2. The hedging needs of writers of TRF products (banks) mean that there is a point of maximum vega for banks in USD/CNH. Below this level banks need to sell USD/CNH vol; above this level banks need to buy USD/CNH vol;

3. The delta-hedging needs of banks are complex. As we approach the average strike (the 6.15 in the theoretical point of Exhibit 1), banks need to buy spot USD/CNH. Above this point but below the European Knock-in (EKI) (i.e., between 6.15 and 6.20 in Exhibit 1), banks need to sell spot. Then above the EKI, banks don’t need to do anything in spot.

From internal Morgan Stanley data, we estimate that the point of maximum vega is somewhere in the range of 6.15-6.20, and that the 6.15-6.20 in Exhibit 1 is reasonably indicative of the average strikes and EKIs in the market.

In other words, so long as the TRF products remain in place (i.e., are not closed out) and we remain below the maximum vega point (somewhere between 6.15 and 6.20), there is natural selling pressure by banks in USD/CNH vol. When we get above that level, there is natural vol buying pressure.

Of course, in the scenario that USD/CNH keeps trading higher and goes above the average EKI level, the removal of spot selling flow by banks and the need to buy vol means the topside move may accelerate.

Simply put, if the CNY keeps going (whether by PBOC hand or a break of the virtuous cycle above), then things get ugly fast...

How Much Is at Stake?In their previous note, MS estimated that US$350 billion of TRF have been sold since the beginning of 2013. When we dig deeper, we think it is reasonable to assume that most of what was sold in 2013 has been knocked out (at the lower knock-outs), given the price action seen in 2013.

Given that, and given what business we’ve done in 2014 calendar year to date, we think a reasonable estimate is that US$150 billion of product remains.

Taking that as a base case, we can then estimate the size of potential losses to holders of these products if USD/CNH keeps trading higher.

In round numbers, we estimate that for every 0.1 move in USD/CNH above the average EKI (which we have assumed here is 6.20), corporates will lose US$200 million a month. The real pain comes if USD/CNH stays above this level, as these losses will accrue every month until the contract expires. Given contracts are 24 months in tenor, this implies around US$4.8 billion in total losses for every 0.1 above the average EKI.

Deutsche Bank concludes...

Looking forward it’s possible that the PBOC is not attempting to actively engineer a sustained depreciation of the Renminbi but rather is attempting to increase the level of two-way volatility in the market to discourage the carry trade and also excessive capital inflows. In terms of the broad risk going forward the sheer scale of the challenge the PBOC has set out to tackle likely means they will have to move with restraint. This is certainly a story to watch...

As Morgan Stanley warns however, this has much broader implications for China...

The potential for US$4.8 billion in losses for every 0.1 above the average EKI could have significant implications for corporate China in its own right, as could the need to post collateral on positions even if the EKI level is not breached.

However, the real concern for corporate China is linked to broader credit issues. On that, it’s worth reiterating that the corporate sector in China is the most leveraged in the world. Further loss due to structured products would add further stress to corporates and potentially some of those might get funding from the shadow banking sector. Investment loss would weaken their balance sheets further and increase repayment risk of their debt.

In this regard, it would potentially cause investors to become more concerned about trust products if any of these corporates get involved in borrowing through trust products. In this regard, this would raise concerns among investors, given that there is already significant risk of credit defaults to happen in 2014.

Remember, as we noted previously, these potential losses are pure levered derivative losses... not some "well we are losing so let's greatly rotate this bet to US equities" which means it has a real tightening impact on both collateral and liquidity around the world... yet again, as we noted previously, it appears the PBOC is trying to break the world's most profitable and easy carry trade - which has created a massive real estate bubble in their nation (and that will have consequences).

+++++++++++++

The bottom line is the question of whether the PBOC's engineering this CNY weakness is merely a strategy to increase volatility and thus deter carry-trade malevolence (in line with reform policies to tamp down bubbles) OR is it a more aggressive entry into the currency wars as China focuses on its trade (exports) and keeping the dream alive? (Or, one more thing, the former morphs into the latter as a vicious unwind ensues OR the market tests the PBOC's willingness to break their momentum spirit).

The escalation of the unwind in recent days suggests the vicious circle is beginning.

Finally, putting aside speculative trader P&L losses, many of which are said to be of Japanese origin and thus will hardly enjoy much or any PBOC sympathies, here is CLSA's Russel Napier on what the long-tern fate of the Renminbi will be:

“Mercantilist alchemy transmutes China’s external surpluses into foreign exchange reserves and renminbi. But with capital outflows from China at record highs, those surpluses are only maintained due to its citizens’ foreign-currency borrowing. Bank-reserve and M2 growth are already near historical lows and are driving tighter monetary policy. This will lead to severe credit-quality issues and force the authorities to accept a credit crunch or opt for a major devaluation of the renminbi. They will do the latter; and despite five years of QE, the world will get deflation anyway.”

The trade of this decade will be to short China & the rest of the BRIC wall.

As bad as things are in the developed world in real, economic terms (and they ARE bad, despite the financial tape painting/lipstick-on-pig sessions) - or more precisely, BECAUSE things are as bad as they are in the developed world - the max pain, wind driven rain will fall squarely against the BRIC plane (not plain).

China is imploding quickly. There is nothing the US or EU can do to contain the damage since we are joined at the hip. Our production capabilities sit in China as factories. Many of the multi-nationals are going to get vaporized when their factories are abandoned.

Australia is massively dependent on China to suck up increasingly larger batches of its resources in the form of raw materials, to be processed into finished goods in China (mainly discretionary goods), to be exported to the developed world.

Yea, I know. I was being a bit sarcastic. We get in these situations because corporations, governments, and rating agencies underestimate or minimize the risk in dependence on or investment in China or any other company printing money like there's no tomorrow. It is a crisis of our ability to come to grips with the fact we are operating on economic theories that don't appear to predict reality, yet we invest, expand and predicate future economic well-being on them. Australia seems like they have a reasonably good economy, maybe organizations will appear in Australia to take the place of those Chinese ones currently processing those raw materials into finished goods.

"Our production capabilities sit in China as factories. Many of the multi-nationals are going to get vaporized when their factories are abandoned."

I'm still forecasting the big propaganda campaign of "Bring back our jobs!" in which US taxpayers will foot the bills for bringing back US factories from China as things deteriorate. Of course, as I've said repeatedly, through the years, companies will only further automate manufacturing processes (always smart to look to do so when you're making a big production shift), resulting in less jobs than originally advertised. Big win for corporate America (again)!

You see, for years and years I have never had a shirt fall apart, and my shirts are cheap - 'cause mrs Proof gets all of my clothes at the thrift shop in the better part of town as part of her garage expeditions on saturday. Slightly worn Pendleton wool shirts for a couple of frn's.

So I realize that the fall-apart stuff never makes it to the yard sales and the donate-after-death places; another reason never to enter Allmart and Tar-J.

Ha! Smart retirement planning! More and more people will retire and head to the golf courses, where you will be able to make a killing selling shirts! </sarc>

I have a relative who "retired" to the golf scene in a sunny/arid location (despite my warnings about water scarcity there- using precious water to turn deserts into golf courses- WTF?). And I opt to never retire, to toil on my land until I drop dead... sometimes I wish I hadn't taken the Red Pill.

This is the most absurd, obtuse, and complicated financial bullshit I have ever thought possible ...

A primer, if you can understand this ...

Conditions are defined in terms of one or two barriers that may be touched:

If they are European, only on the expiry date of the option.

If they are American, at any time during the lifetime of the option.

If there is a payout, it is that of the underlying vanilla option.

Why use barrier options?You would use a barrier because of both the following reasons combined:

It is inevitable cheaper than its equivalent vanilla counterparty.Why? This is because it has a risk of being knocked out, or of not being knocked in. By a similar logic, a double knockout option is cheaper than a single knockout option because it has two two knockout barriers and thus double the risk of being knocked out.

You have a particular take on the movement of the underlying (that is, the spot in the FX market, the nearest future in the CM market for metals, etc.) that makes the risk of the added barriers worthwhile.

Example of a barrier optionYou need to hedge a short USD/CHF exposure, and the spot is currently 1.4500 and the forward rate is 1.3900.

You can achieve this buying a regular vanilla USD call option. However, a more effective way to hedge this exposure could be using a knock out barrier option—a USD call with a knockout strike of 1.4000 and a knock out barrier of 1.3700.

Why is this more effective than the vanilla alternative?

The knock out option gives you the right but not the obligation to buy USD against CHF at 1.4000, as long as the spot never hit 1.3700 during the life of the option. However, should the spot reach 1.3700 before the expiry date then the option is automatically terminated.

Firstly, because of this risk, that the option may be terminated before the expiry date, the knock out barrier option is cheaper than the vanilla option (420 CHF pips as opposed to 590 CHF pips). That is, if the option finishes in-the-money without having reached the outstrike, your underlying exposure was always protected from an unfavourable spot movement but for a cheaper premium than if you had purchased the vanilla option.

Secondly, the Knock Out option only exists when you need it (if the spot moves in an unfavorable direction) and only ceases to exist when the spot market has moved in favour of the underlying exposure, giving you the opportunity to close your underlying position at a favourable rate or to reassess market conditions.

If however, the spot should hit the barrier before the expiry date, it is advisable to take action in the form of a spot, forward or option to avoid being unhedged for the remainder of the hedge period. This is because after hitting the barrier (and knocking out the hedge protection) the spot may retrace itself and finish in-the-money.

whats worse, the chinese as an intenational gold backed reserve currency, or the good ol USA? time has shown us that every nation in this position has managed to screw itself over. they never have any transparency. its bananas.

It's a carcass that's being picked apart by vultures. All is heading toward an entirely different way of life, one that not even the "clan" can control (though that never would stop them from trying). Think of it like the Easter Islanders' last days, fighting for supremacy measure in statue prowes, probably were trying to hoard statues right up to the end; and after it all collapsed I doubt that folks had any desire to continue statue building. The "clan" knows the game of marbles. In the future the game of marbles won't be played...

PUBLIC NOTICE“To Whom It May Concern”Worldwide Banks & “Governments” Foreclosed

BACKGROUND TO GLOBAL FORECLOSURESA two-year investigation by The One People’s Public Trust (OPPT) discovered the massive fraud that‘banks’ and ‘corporate government’ have systemically perpetuated against the people of the entire world over many decades.

OPPT’s final report concluded that a debt slavery system had been deliberately set up by the heads of the banks and corporate governments, and whether we realized it before or not, this system gradually entrapped almost every human being on earth for the duration of their life. The report also concluded that the existing system could not be fixed and that a new legal landscape had to be created to free the people of the earth from debt slavery. (Report http://i-uv.com/oppt-absolute/oppt-initial-investigation/)

So, using the same legal process that the banks, corporations and corporate governments have alwaysused to ‘foreclose’ on unsuspecting individuals, OPPT lodged various commercial filings during 2011,2012 and 2013, using what is called the Uniform Commercial Code (UCC). The banks and corporate government entities were given plenty of time and opportunity to ‘rebut’ the filings, but to date no rebuttals have ever been registered and so the UCC filings were accepted as Rulings and therefore, came into existence as global law.

UNIFORM COMMERCIAL CODE – WHAT IS IT? WHERE AND TO WHOM DOES IT APPLY?The Uniform Commercial Code (UCC) is the ‘bible’ of ALL commerce and is used worldwide by high-level banking and government corporations to manage and govern their transactions and commercial behavior at an international level. Sadly, ‘UCC’ is not taught in law schools so most lawyers, attorneys and magistrates know nothing about UCC and will argue it has no application. However, given the usage of UCC filings in the upper levels of “government” and banks worldwide, due diligence and working knowledge of the UCC is a necessity. UCC Resources:1) http://www.law.cornell.edu/ucc/ucc.table.html2) http://en.wikipedia.org/wiki/Uniform_Commercial_Code3) http://australian-commonwealth.com/ucc.html

HOW DID THE FILINGS COME TO BE GLOBAL LEGAL RULINGS?After the investigation was completed, the OPPT made two very important conclusions that were set out in the original UCC filings:? 1. that they (the banks and corporate governments) had by deceptive acts and practices been stealing from the people for hundreds of years, and; 2. nothing stood betweenthe Creator and each of the Creator’s creations.

Refer: DECLARATION OF FACTS: UCC Doc # 2012127914 - Nov 28 2012Government Charters Cancelled:“...That any and all CHARTERS, inclusive of The United States Federal Government, UNITED STATES, “STATE of ...", Inclusive of any and all abbreviations, idem sonans, or other legal, financial or managerial forms, any and all international equivalents, inclusive of any and all OFFICES, inclusive of any and all OFFICERS, PUBLIC SERVANTS, EXECUTIVE ORDERS, TREATIES, CONSTITUTIONS, MEMBERSHIP, ACTS, and any and all other contracts and agreements made thereunder and thereby, are now, void, worthless, or otherwise cancelled, unrebutted; ...”

WHAT DO THE UCC RULINGS MEAN FOR BANKS & CORPORATE GOVERNMENTS?All beings now act in the capacity of individual entities without a corporate safety net and with full personal liability for each and EVERY ACTION THEY TAKE under common law, protected and preserved by public policy UCC 1-103, and Universal law, the governing law laid out in the OPPT UCC filings. (Refer: WA DC UCC Ref Doc # 2012113593). Should any individual pursue any actions on behalf of a foreclosed Bank or “Government”, causing another individual any damage as herein described, they in their individual and unlimited capacity are absolutely liable. Such actions may result in the receipt of a Courtesy Notice.

WHAT IS A COURTESY NOTICE?The Courtesy Notice contains the information of this flyer and offers terms and conditions for any future dealings an agent of a foreclosed entity may wish to have with you. Individuals are now downloading and sending Courtesy Notices worldwide; 64,000 were downloaded in the first two days following release in early Feb 2013. (See http://i-uv.com/oppt-absolute/oppt-tools/which-courtesy-notice/)Share your Public Notices here: www.pn.i-uv.com

WHAT DOES THIS MEAN TO YOU? All People Declared Free of DebtRefer: NOTICE OF DECLARATION OF ABSOLUTE TRUTH UCC# 2013032035)The final filing of the OPPT occurred on March 18, 2013. This document terminated all remaining man- made entities and returned all people of this planet to absolute freedom. In this document the creator is referred to as "absolute essence" and all creation’s people are referred to as "absolute essence embodied". Article VI states..."I duly verify, with full responsibility and liability, by DECLARATION OF ORDER, that eternal essence IS made transparent and known by the DO'ing of any and all embodimentof eternal essence in eternal essence's universe, IS free and free of debt, unrebutted."

This means THERE IS NO DEBT.? You have no debt... No one has debt... it is done. This includes your mortgage, credit card and car or student loan. There is simply NO MORE DEBT.FURTHER RESEARCH

2. UCC Doc # 0000000181425776 filed 12 Aug 2011 evidences sale of US citizens in transaction between The Federal Reserve System and The United States Department of the Treasury 1789 for $14.3 trillion. (Linked above)

3. UCC Doc #2001059388 evidences the template the Federal Reserve Bank of New York uses to secure the collateral in major banks around the world... including chattel paper, goods and the unborn young of animals. (See http://www.mediafire.com/view/?3yh79cjnzcwzu0s )

Countries and ‘Governments’ Are Just Corporations, on the USA Stock Exchange and Dun & Bradstreet Go to http://www.sec.gov/edgar/searchedgar/companysearch.html and search for your country under “More Options” using either 8888 (Foreign Government ) or 8880 (American Depositary Receipts) as the SIC code. There you can research your country as a registered company on the USA Stock Exchange.You can even review your country’s Annual Report. Go to this List of Duns Numbers for US Corporate Governments and you can see many US federal, state and local governments listed with their business Dun and Bradstreet identification number.

Volunteers within the military ... “to arrest and take into custody any and all certain states of body, their agents, officers, and other actors, regardless of domicil by choice, owning, operating, aiding andabetting private money systems, issuing, collection, legal enforcement systems, operating SLAVERY SYSTEMS against the several states citizens, ...”, and “Repossess all private money systems, tracking, transferring, issuing, collection, legal enforcement systems operating SLAVERY SYSTEMS...”

“...all beings of the creator shall forthwith assist all Public Servants identified herein, to implement, protect, preserve and complete this ORDER by all means of the creator and created as stated herein, by, with, and under your full personal liability...”

Because a CEASE AND DESIST order exists, you are free to offer terms and conditions to individualsacting on behalf of a foreclosed Bank or “Government”, by issuing a Courtesy Notice.

Only because I have fought the fight agains banks using "tinfoil hat" theories...and am winning so far, that I understand some of what is above. I do know I can become a secured party creditor as I have done that with UCC. So...will look at the rest after I burn a fatty.

-- "UNIFORM COMMERCIAL CODE – WHAT IS IT? WHERE AND TO WHOM DOES IT APPLY?The Uniform Commercial Code (UCC) is the ‘bible’ of ALL commerce and is used worldwide by high-level banking and government corporations to manage and govern their transactions and commercial behavior at an international level. Sadly, ‘UCC’ is not taught in law schools so most lawyers, attorneys and magistrates know nothing about UCC and will argue it has no application."

That's odd. I had an entire course in UCC in undergraduate business school. You mean most lawyers, attorneys and magistrates don't know anything about something that I know something about (admittedly very little)?

Believe me the UCC is well understood by the legal bar, not so sure about the poster here. Sounds a bit like a guy who told me that he had declared his soverignty and was not longer responsible for federal income taxes. That was right before all of his accounts were frozen.

Everything, except food and energy, is getting to be more and more worthless. One day in the future most all you see around you will be meaningless: if you have to have an abondoned vehicle in your yard make it a truck, as at least it can make for a planter...

I'm surprised that no one reports FX loss in the 1Q. Zero hedge please keep track of those 'victims'. Are those people all Chinese? or are they global? To what extent 'mark to market' rule is not applied to the FX 'assets'?

The situation with steel company debt continues to deteriorate. Last year there were a total of 2500 lawsuits at the relevant court in Pudong, Shanghai; in the first quarter of 2013 there were 1051 lawsuits. Last year the cases amounted to ?19 billion, this year they are already ?11.4 billion, in other words the average case in 2013 was about ?7.6 million, but this year it is up to ?10.8 million, an increase of 40%. The situation is expected to continue worsening into next year, with concern that this is still the tip of the iceberg.

OT: $16 billion worth of AAPL changed hands so far today with a stupendous gap. That's enough volume to cover the entire short interest and then some. Which long/short hedgies got their ass splattered?

Yes China is on the edge. China has entered a great credit trap and is awash in overcapacity and debt. Much of the recent growth in China after 2008 came from a massive 6.6 trillion dollar stimulus program that expanded credit and poured massive amounts of money into the system. This money encouraged expansion and construction with little regard as to real demand or need.

After several years of growing debt concern is rising the whole unstable pyramid is about to come crashing down bringing China and possibly the global economy with it. This is not just about writing off a few bad loans. The shadow banking sector is so large that concerns exist about contagion and a domino series of defaults that might rack the economy as savers lose money. More on this subject in the article below.